I’m still confused about this whole Eurozone thing …

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This post is a guest contribution by Rebecca Wilder*, author of the of the News N Economics blog.

This is a post about my confusion, rather than my reporting, of the Eurozone saga. Here are some pieces worth reading if you want to catch up:

The NY Times (the basics): Ed Harrison (via Naked Capitalism); From the billy blog; The Financial Times (Martin Wolf, a must read); The Economist (will reference below).

Okay, a conditional guarantee for possible lending, maybe, only with consultation from the IMF has been agreed upon by the Eurozone countries (Germany and France, really). But what I don’t understand is pretty well stated in the Economist article:

The Greek government has somehow to keep its economy on an even keel while pushing through a huge fiscal tightening. Countries that seek IMF help generally have to endure brutal cuts in public spending, which deepen recessions. To counter that effect, the IMF typically counsels a weaker currency. Sadly, this is not an option for Greece. Stuck in the euro, its exchange rate with its main trading partners is fixed. Greece cannot devalue, so it needs more time to adjust than the three years it has agreed with its EU partners—and a bigger safety net while it does.

Sadly? This is not an option? The Economist completely skips over the VERY LARGE issue of a currency peg in order to focus on the increased competitiveness that must be derived through internal devaluation, i.e., dropping wages and other nominal variables.

Financial crises, especially those in small-open economies (Sweden, for example), generally end with a massive currency devaluation that drives export growth (provided there is external demand to suffice). I honestly don’t see how a sufficient export-generated rebound is even a possibility, given that the rest of the Eurozone is essentially trying the “internal devaluation” bit simultaneously (chart above).

And who’s going to pick up the slack? In 2008, 64% of Greece’s export income was derived by the EU 27 countries, 70% for Spain, and 74% for Portugal. If the Eurozone as a whole is using this same internal deflation mechanism to spur export growth, only the “zone” as a whole really benefits, not any one country.

Without a massive surge in export-driven GDP growth no “zone” country can drop its financial deficit without incurring behemoth debt burden growth (in the case of the Eurozone, the term “burden” actually applies since Greece, nor any one economy, can print its own money).

Look at the government’s period budget constraint (left), where the lower-case letters “d” and “p” stand for the debt and primary deficit as a share of GDP, respectively. r is the nominal interest rate, and (1+g) is the rate of NOMINAL GDP growth (including price appreciation).

When Greece starts dropping p (the primary deficit), the fundamentals of the economy (i.e., nominal gdp growth (1+g)) must be robust enough to prevent a surging debt burden. And here’s the cycle: to drop the primary deficit, it does so by reducing G and raising T, which drags Y (as of Y = C + I + G + Ex – Im) and growth of Y, (1+g), since export growth is unlikely to be there to offset the decline in private spending; these effects then flow back to the primary deficit to raise p.

And likewise, only under the circumstances of heroic export growth can the government reduce its fiscal deficit to 3% WITHOUT the private sector levering up their balance sheets and contributing to a larger default risk (of the depressionary type). I’m confused.

All I’m saying is that this plan, in its current form, is really not much of a plan at all. The export competitiveness story is getting old, let’s think of something new.

Source: Rebecca Wilder, News N Economics, March 11, 2010.

* Rebecca Wilder is an economist in the financial industry. She was previously an assistant professor and holds a doctorate in economics.

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2 comments to I’m still confused about this whole Eurozone thing …

  • Pkpetro

    The so-called EU “bailout” deal for Greece just announced is a joke. Greece must exit the eurozone, devalue the drachma, restructure its debt and borrow from the IMF at 3.5% interest, if needed, instead of at 6% from the markets or from its eurozone “partners”.

    Whether there is in fact any point remaining in the EU at all is a valid question. Because it is well established in economic theory that a monetary and trade union increases the divergences in competitiveness, and this is the root of the problem. Because intra-EU imbalances and structural weaknesses are now too evident. And because, without solidarity, the EU is kaput.

    This is the best course of action for all the GISPI (Greece, Italy, Spain, Portugal, Ireland). Let the FUKD (or FUKDE, as Edward Hugh has called them, i.e. France, UK, Deutchland ) keep the EU for themselves. Sorry UK, you’re not to blame. You did the right thing staying out of the euro.

    And let the Germans sell an island (in the North Sea) and a monument (as they have suggested to the Greeks), because they are also now above the 3% deficit-to-GDP ratio. Did I say German monument? What monument???

    Now how can Europe, which owes even its name to Greece, exist without Greece, that’s another question.

    Apart from the so-called “moral hazard” in helping Greece, there is also a moral deficit in the EU…

  • Paul Sandison

    In the early 1990s I warned all my friends in Greece that Greece should not join the Euro because I feared that exactly something like this crisis would happen to Greece.

    I agree with PkPetro that leaving the Euro is one solution, although the massive drawback for Greece would be that the drachma would depreciate in relation to the Euro and the foreign loans would then become an impossible burden for Greece. So Greece would have to both leave the Euro and default, which would create a financial shock to the lender countries, and invite economic retaliation on Greece such as a surcharge on imports from Greece.

    The EU would have a grave internal crisis on its hands and would have to decide how it would try and obtain compensation for the losses suffered by its member countries for the Greek default. The outcome would be very nasty and even with a free-floating drachma Greece could struggle for a decade or more to rebuild its economy and reputation as a reliable business partner.

    The UK has over £100 bn in outstanding loans to Greece and the pound would sink further if Greece defaulted. A full-blown economic crisis in the UK which is due to happen anyway would be brought forward earlier than otherwise. Since the whole financial world is now interconnected the effect on the global economic recovery which is probably due for a second dip this year would be negative.

    By the way, for all those who may know nothing about Greece, the average Greek person works way more man-hours than labour in any other country in the developed world. So the accusations that abound right now that Greeks are lazy, are pejorative and scandalous. Greece has been lured into a box. Many economists warned at the time that the Euro was not suitable for such disparate economies as that of France and Germany which are heavily industrialised, and the Mediterranean countries which have a considerable reliance on agriculture and tourism.

    The people of Iceland rejected the terms of the loans offered to assist Iceland to repay the British banks. Similarly it is the interest rates of the loans taken by Greece and made by Greece in the future which are absolutely crucial. Current interest rates are 3% within the Euro zone. If the EU countries and the IMF which are to guarantee the loans which may or may not be needed by Greece play hardball and insist on punitive loans carrying 6% interest then they risk a default by Greece and quite understandably so.

    The EU in its desire to punish Greece for cooking the books on entry to the EU and for wildly overstepping the 3% deficit limit, is obviating the realpolitik necessary to enable Greece to repay its debts. The EU should also realise playing hardball is foolish in the extreme. A default by Greece would make other countries question membership of the Euro zone and the Euro would collapse.

    Rebecca, I do not understand the relevance of your mention of Sweden in the context of your discussion.

    You write that Sweden generally devalues its currency to promote exports. That was from the old era when the UK and Sweden and many other countries regularly devalued their currencies when they had a fixed currency system. Since the early 1990s, however, many countries like Sweden and UK have allowed their currencies to float and so they cannot devalue their currencies. The market determines the exchange rate.

    During this present crisis the Swedish krona has not depreciated. It has appreciated slightly towards the Euro and the British pound but depreciated slightly in relation to the (temporarily) strong dollar and the currencies with a relatively stable banking system like Canada and Australia.

    Sweden has a current account surplus and having maintained a relatively austere fiscal policy since the early 1990s can now afford for example tax rebates for pensioners, although their income tax is not yet entirely back on a par with income earners. Sweden’s GDP is growing at 3%.

    While it is absolutely true that Sweden is a small, open economy, all that means at the moment is that it trades with the rest of the world. In other words its GDP is highly dependent on other countries importing its goods. If Sweden’s trading partners do well they buy from Sweden and Sweden does well. Thus Sweden is, as it always has been, very vulnerable to economic shocks in other countries that cause a reduced demand for Sweden’s products.

    Therefore I cannot see the relevance of Sweden’s membership of the EU in your discussion, except that its membership automatically requires the adoption of EU standards which is an advantage when Sweden trades with the rest of the EU, and Sweden has full influence in EU affairs, except when it comes to the Euro zone and the monetary policy of the Euro zone countries as implemented by the European Central Bank.

    Perhaps you could explore the differences between the economy of Sweden and that of Greece. The krona floats and therefore Sweden, unlike Greece, has control of both monetary and fiscal policy whereas Greece has one hand tied behind its back since it can only control its economy with fiscal policy.

    Sweden’s economy is high-tech and diverse and there is still a large secondary industry. Greece has two main industries, tourism and agriculture. This lack of diversity makes it particularly vulnerable to a drop in tourism during a global economic crisis such as the present one.

    However the main difference why Greece is struggling while Sweden is prospering is that Sweden remained outside the Euro zone while Greece went in. Part of monetary policy is the power to set interest rates. Sweden has been able to judiciously set its own interest rates to suit its own economy while Greece has had to try and accommodate shocks to its economy with an interest rate which is set in accordance with the needs of the economies of the industrial powers of France and Germany.

    The economic problems in Greece also pre-date the 2007-2009 crisis. As soon as Greece joined the Euro, prices and wages rose in Greece to European levels which naturally put off foreign tourists who switched to other tourist destinations such as Algeria, Egypt, Turkey and the other countries which can still control their own monetary policy.

    Unless the GISP countries (Greece, Italy, Spain and Portugal) can develop other industries to diversify away from tourism, the basic imbalance will continue. Spain is developing CSP Concentrated Solar Power which will reduce oil imports and ultimately enable Spain to export energy to the cooler part of Europe to the north. Although I know that Greeks have studied alternative technology such as CSP in the UK since 1995, as far as I know it has not been adopted as part of a structural reform for Greek industry.

    Ultimately, if one is to have a common currency at all the Euro should not have been created without a common fiscal structure to balance it. But that requires a federal state apparatus which goes far beyond that which most member states have been able to agree on. In the beginning of the 1990s there was a lot of talk of a two-stage or even two-speed solution with a federal government which would control government taxation and spending for all those in a Euro zone, but not for those who did not wish to join the Euro zone.

    As part of this idea other countries like the UK, Sweden and the GISPI would have been members of the EU but not the Euro. Nothing came of the federal fiscal idea, because those outside the Euro felt that they would then lose influence over wider Federal Government economic policy.

    The present arrangement with some EU countries inside the Euro zone and some outside is in itself a two stage or two sphere arrangement. The EU is full of other anomalies and dysfunctional structures. It has a largely powerless Parliament, a largely autocratic Council of Ministers that is not responsible to the Parliament and a massive bureaucracy. Perhaps a full union with a representative democracy and a government chosen directly by the people plus a Central Bank made up of the Central Banks of member countries like Greece would have worked.

    An intelligent federal fiscal and monetary policy always accommodates regional differences and promotes growth and prosperity in areas which are struggling. But the EU does not have a fully democratic Parliament and an elected Federal Administration which is entrusted with fiscal policy. Also, the European Central Bank unlike the Federal Reserve Bank in the US, does not have the twin goals of controlling inflation and promoting growth. The European Central Bank only has a mandate to control inflation.

    Historically, many unions have come about by conquest. The Roman Empire, the Holy Roman Empire, the Soviet Union, the Union of South Africa, are examples. Even the US only settled down as a union after the Civil War. To try and achieve a Great Union by peaceful means as the EU is doing means that great attention has to be paid to the needs of members and the arrangements for democratic representation for each of the member states in that union. That has not happened.

    Historically, other political unions have come about through the marriages of Kings and Queens. Indeed, a political union is like a marriage union. However, today, to work well, both members must be prepared to take democratic decisions together for the maximum benefit and happiness of both. No-one wants to lose their autonomy unless they are assured of true democracy in the union. This is why a union of states can only be undertaken after a lot of practice at co-operating in democratic control, for the maximum satisfaction of all partners. Suitably, in this discussion, it should be remembered that democracy and autonomy are ancient Greek concepts.

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